The private equity power shift

Not too long ago, private equity fund managers were subjected to little due diligence as investors rushed to write checks before being shut out. Now investors are in charge.

“They came in to interview our CFO and controller, to ask about our internal controls, how we manage cash and the educational background of our financial back-office employees… They also wanted to know about our human capital policies, like securities trading and political donations.”

Philip Canfield, principal of private equity firm GTCR

That isn’t the CEO of a company under investigation for financial irregularities. It’s Philip Canfield, principal of private equity firm GTCR, describing the increased scrutiny that groups like his are facing from prospective investors.

“We anticipated that due diligence would be more rigorous this time around, but the depth of it still managed to surprise us,” Canfield adds. “There was deep probing into areas where, in the past, there was an assumed level of competence.”

It’s hard to blame Canfield for being taken aback. His Chicago-based firm has been around for more than 30 years, has produced above-average returns and has stuck to its “platform-based” investment strategy when those around it were chasing fads. Moreover, GTCR was known to have some of the industry’s most investor-friendly fund terms, such as not hogging so-called “deal fees.”

Ultimately, GTCR was successful. The firm raised $3.25 billion for its tenth fund, compared to a target of just $3 billon. But for most of the past year, Canfield and company felt compelled to ask “how high” when its investors said “jump.”

One of those investors is John Morris, a managing director with Boston-based fund-of-funds manager HarbourVest.

Morris acknowledges that due diligence has gotten more stringent over the past year, and that firms like his no longer feel pressure to make quick decisions.

“We are now doing a lot more analysis of unrealized investments, and have the flexibility to take a wait-and-see approach with how they perform over a couple of quarters,” Morris says. “We are no longer concerned about getting shut out of a fund if we refuse to commit immediately.”

Other fund investors talk about interviewing every CEO that a private equity firm backed in its last fund, to understand how much of that company’s success or failure is attributable to the firm (as opposed to larger market forces or company management). Or how they try to figure out which PE firm staffers are responsible for each and every deal, rather than just focusing on the best and worst performing transactions.

All of this is part of a larger power shift within private equity, where fund managers traditionally have lorded over their own investors (“If you don’t want to invest today on our terms, we can easily find someone else who will”). Today, it’s the investors who are in charge – largely due to prolonged liquidity challenges that caused them to slow down new commitments and seriously reexamine existing relationships.

For example, research firm Preqin reports that the average private equity fund closed in 2010 had been in market for 18 months, up 50% from early 2008. GTCR was an exception to this trend with just an 8-month fundraise, but there are plenty of shops that have been at it for more than two years.

Such lengthy and detailed processes will be the norm for the hundreds of private equity firms that try to raise new capital this year. The more interesting fundraisings, however, may come later.

“I think these things are cyclical,” Morris says. “At some point in the future, I’m sure funds will get raised faster with fewer questions asked. But I don’t think any of us know when that future will begin.”